The focus will now be on the capital markets & the economy in longer
trm perspective...I have wanted to do this for a long while and have
wearied of outlining near term perspectives...Short term opinion has
become an overcrowded field...

About Me

Retired chief investment officer and former NYSE firm
partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader,
and CIO who has superb track
record with multi $billion
equities and fixed income
portfolios. Advanced degrees,
CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms:
CAVEAT EMPTOR IN SPADES !!!

Thursday, February 25, 2010

To study long term inflation potential, I derive a base inflationrate by taking the 10 yr. growth rate of money M2 minus myestimate of economic growth potential. Inflation potential did riseover the past 10 - 15 yrs to roughly 3.5% per annum on a moderateacceleration of money growth and a reduction in economic growthpotential, with the latter reflecting a slowing in the growth of thelabor force.

Inflation averaged about 2.6% over the past 10 yrs. compared toinflation potential of 3.5%. The shortfall obviously reflects bookendrecessions, which impaired demand growth. But it also reflects a longterm downtrend in the rate of capacity utilization. In fact, the lasttimes the economy operated at effective full capacity was in the 1994-98 interval. With low output growth over 1999 - 2009 also came asubstantial increase in the trade deficit reflecting in significant part aninflux of lower priced goods from abroad. This development coupledwith a sharp net increase in the off-shoring of jobs contributed tolower labor costs. Even commodities prices, which did put upwardpressure on the inflation rate after 2002, collapsed over the back halfof 2008 before commencing to recover.

We start the new decade with very large excess slack in the USeconomy and globally as well. Inflation potential over the next severalyears will remain around 3.5%, but to sustain that kind of elevatedlevel will require a substantial increase of operating rates andenough of a recovery in the labor market that workers can begindemanding and getting stronger wage gains. Upward pressure on theinflation rate from the occasional flare up of commodities prices is notlikely to prove sustainable without significantly higher levels offacility and labor utilization.

Tuesday, February 23, 2010

I am looking for the 12 month CPI measured yr/yr to be about 2.5%for 12/10. It was 2.7% for the comparable period over 2009, butthat is primarily because of the slide in prices over Half 2 '08 thatbrought the CPI to depressed levels.

The inflation pressure gauges I use did recover strongly over thecourse of 2009, but will have to rise much further over the courseof this year for the CPI to reach the 2.5% by year's end. The CPI,when measured without food and fuels prices, is in a significantdowntrend presently, and this trend could last through at least Q 2'10 if not longer (The yr/yr reading through 1/10 is 1.6%). Postrecession downtrends of inflation excluding foods and fuels can wearon for 15 - 24 months. As matters presently stand, it appears thatcommodities prices are going to have regain substantial upsidemomentum as 2010 progresses to offset the drag effects of othercomponents if the 2.5% target is to be reached.

The broad CRB commods. composite rose sharply over much of2009 but has been on a plateau since Nov. and has been losing pricemomentum since mid-2009. Chart. So, we are going to have to see arevival in the speculative juices of commodities traders to get thisindex moving up again.

Another measure I watch closely is capacity utilization. That has beenrising sharply in recent months from very low levels to reflectinventory rebuilding and strong export sales. Hefty rebounds inboth US and China maunufacturing remain in force and that is asupportive force for inflation. Heavy inventory speculation in Chinahelped power commodities prices in 2009. A recent tightening ofcredit standards by China banking authorities has cooled speculativeinterest in raw materials both within and beyond China, but themandate from the top is to maintain strong growth there.

The CPI made its all time high in Jul. '08 and has yet to surpass thatlevel. So, technically, the US is still experiencing deflation. I use asmoothed calculation of the CPI to drive my 91 day T-bill interestrate model. The deflation the US experienced has not been steepenough to warrant a ZIRP policy. The model currently implies the"Bill" should be 2.1%. Clearly, then the Fed has waived off arecovering CPI to support the financial system and an economicrebound.

Sunday, February 21, 2010

As I have discussed over the past six months, when the realeconomy grows faster than the broad monetary/credit liquidityaggregate, a type of liquidity deficit develops, as the real economydrains liquidity available to the capital markets, especially thestock market. When this occurs late in an economic expansion cycle,it is usually because of monetary/credit tightening by the Fed andis normally fatal to a cyclical bull market. But a liquidity deficit canoccur during an economic expansion if economic momentum isstrong and credit growth is modest or deteriorating. We last sawthis kind of liquidity deficit from y/e 2003 through mid-2005.

When a deficit occurs as in the 18 months out from y/e 2003, it canact as a headwind for the stock market even if earnings areprogressing well and short term interest rates are not threatening.In the 2004 through mid-2005 case, the SP 500 advanced about6.5% or roughly 4.3% on an annual rate basis. That is sub-parperformance.

I do not think a liquidity squeeze of the sort described above isnecessarily going to retard the stock market's cyclical progress,but it is logical to think that it will, especially if ready portfoliocash levels among the various funds are low. Since the lattersituation probably obtains today, it seems wise to keep theliquidity deficit in mind.

It is likely that the current economic recovery will lose some ofits growth momentum by mid-2010, as low inventory levels arefinally replenished. Moreover, later in this year, we may seea positive turn in private sector credit demand. Both developmentswill ease the squeeze on liquidity and lessen its headwind effect onthe stock market.

Measured yr/yr, the $ cost of US production is up 1.9% aftermonths of deep negative readings (which created a liquidity surplus).Looking yr/yr, my broad measure of credit driven liquidity is a-3.7% through Jan. Thus the liquidity barometer I use is a sharp-5.6. The deficit should increase in the months ahead before thereis a good chance for reversal.

Thursday, February 18, 2010

In the market technical post back on 2/1, I opined that the marketerosion had yielded up a tradeworthy oversold. We wound up withan interval of choppy waters suitable for day traders, but a moresolid rally did start up last week. The significant short term oversoldhas been eliminated. There is now upside to 1130 -1140 before achallenging overbought would be in place.

Thanks for the rally. I'll leave the remaining short term upside toothers as I am curious whether some cyclic themes will play outwhich suggest a more definitive shorter run bottom over the next5 - 10 odd trading days. And, "curious" is the operant term here.I have seen cycle action get busted enough times not to getreligious about them. But, since this cyclic play is one I happenedupon without any coaching, I look forward with enjoyment to seeif it plays out or if it is a mere passing phase.

Tuesday, February 16, 2010

A cyclical uptrend in corporate bond yields turned into a rout inthe latter part of 2008, as economic free fall spread fear rapidlythrough the corporate bond market. However, by late in the year,investors began to recover confidence that strong companies andtheir bonds could weather the storm. It was not smooth sailingthough as another wave of fear gripped the market over Q1 '09before bond prices firmed again and yields fell.

In the early stage of an economic recovery, investment gradecorporate bonds can fare better than Treasuries as investorsgain confidence in the business outlook and do sector swaps fromTreasuries into high grade corporates and subsequently into lesserquality credits. Moreover, the willingness to assume greatercredit risk can lead to rising corporate bond prices even as Treas.prices fall. This rotational process can go on for an extendedperiod, especially if short rates are so low that investors pushextra hard to pick up yield.

So, it is interesting that high grade corporate yields havestabilized and advanced in recent months. Top grades trade ata roughly 200 basis point premium to 10 yr Treasuries whenit would not be surprising if they traded at only 100 bp over the10 yr. Note also that yield spread between high grades and lesserlight BBBs is also still relatively wide. This does suggest that thereremains residual investor fear about how solid and durable theeconomic recovery may be. The fast answer is that as the economyproceeds with recovery, confidence will grow and yield spreadswill narrow further in the bond market. That is not a troublingresponse as it stands. However, because high grade yields havebeen moving more sympathetically with Treasury yields, playershave to keep in mind that further swapping out of Treasuriesinto corporates could be accomplished as both yield levels riseand that further swapping need not produce rising prices forcorporates and falling yields. In short, narrowing yield differentialsin quality may not assure the elimination of price risk as youpurchase corporates. If you are using bonds in your investmentportfolio, keep this issue in mind since an upturn in corporateyields could accompany the same in the Treausry market.

Friday, February 12, 2010

As I mentioned in the 2/9 post, I use a momentum indicator based onthe $ cost of industrial commodities production (6 mos. Ann./rate). Ilong ago rolled this into a much broader macro measure and use thelatter, broad measure as a long Treasury direction measure as well.Both guides are trending up, but momentum is slowing becauseboth industrial commodities and the broader CRB index have lostthrust.

Interestingly, since 2004, the Treasury market has been lesssensitive to upsurges in the CRB commodities index as well as theCPI. My guess here is that the Treasury market players regard afast rise in oil, petrol and natural gas prices as a tax on consumption,figuring that it will penalize real incomes and confidence and thusbring about slower real economic growth. This could be an instance ofa broader issue, namely that an acceleration of inflation which quicklyoutstrips wage growth will eventually punish the economy, not tomention force the Fed into tightening moves. So, in deciding aboutthe merits of the bond market, you may have to study the inflationdrivers and not just the CPI overall.

I also plan to watch the Treasury yield more closely compared to themomentum of the leading indicators, since bond players clearlynow figure that once growth momentum fades, inflation pressures willabate and the Fed may ease credit. Leading indicator momentumhere (Scroll down).

In summary on this point, bond players now regard inflation as bothlimited and cyclical. That could all change in the future, but you willneed evidence which contradicts first.

The long Treasury yield has taken off rapidly against a ZIRP forshort rates. Bond players are figuring that sooner or later, the Fedwill push up rates as economic recovery proceeds and are notwaiting. By super long term historic standards of positively shapedyield curves, a 4.60% long term Treasury implies a 3.0% 91 dayT-bill. Here, it is possble that once short rates lift, the Treasuryyield may exhibit below average sensitivity to it. Something toconsider. You also have to keep in mind that if economic momentumslows during the ZIRP interval for short rates, bond traders couldanticipate a fast long side trade with Treasuries, reasoning that lessmonetary accomodation will be postponed.

It is possible that with the large budget deficits on tap ahead, theTreasury yield could develop a "supply premium" as investorsdemand a higher yield in lieu of upcoming heavy new issue volume.Too early to tell on this I think.

Bond analysis has become more complicated and dynamic, but Ithink it is still manageable. I hope these additional comments provehelpful.

Tuesday, February 09, 2010

I want to post some work on the bond market, so I thought I wouldstart with my favorite -- the long Treasury. Inflation has been in along term downtrend for around 30 years. So has the long Treasuryyield. Moreover, as investors have gained confidence that inflationwas staying in its downtrend, they have demanded a smallerpremium in yield over the inflation rate as time has passed. To topit off, the Treasury bond has been a good forecaster of the inflationtrend over time, and as investor confidence in the market hasincreased, the bond yield has become less sensitive to shorter termswings of inflation.

The bull market in Treasury bond prices that has accompanied thelong run downtrend of yield has been one of the great fixed incomebulls of all time. And, since inflation pressure has subsided by such alarge margin over the years, it would be flippant simply to proclaimthe demise of the bull.

Over the 1988-98 period, the premium in the yield of the long Treas.over the CPI (yr / yr) ranged primarily between 300 - 500 basispoints (3% - 5%). Since then, the premium has eroded to a range of200 - 250 bp when monthly extremes of inflation / deflationreadings are X'd out. When I use a constant 3% inflation rate, therange in premium is 130 - 230 bp excluding the outliers.

Short term changes to the inflation rate have heavily reflected theswings in the commodities market over the past 10 years, mostnotably oil, petrol and natural gas. So, in looking at the Treasurymarket, I have grown more comfortable with the idea of a constant3% inflation assumption. On this basis, the 30 yr. Treas. -- now4.55% -- should yield between 4.30 - 5.30%. Since the presentyield is at the lower end of the range, I conclude inflationexpectations are subdued.

On a short term basis, the Treas. bond yield is most sensitive to anindex of the momentum of the $ value of sensitive materialsproduction. When the economy went into free fall starting in mid-'08, that index stood at 117.9. It plummeted to an extraordinary lowlevel of 40.0 by 1/09. It has since shot back up to about 130. Thebond yield followed the same "V" pattern as you know. Since theheavy industry momentum index is now at an unusually high level,I suspect the upward thrust on the Treasury yield has seen its peakin the short run.

I do not see much reason for upward pressure on the long Treas.yield in the short term. However, as the economic recovery persists,there will be a couple of more upswings in sensitive materials prices.On top of that, the Fed will eventually push up short rates, andbroader cyclical pressure will lead to more acceleration of inflationpressure. So, over the next 12 mos. it seems reasonable to expecta cyclical rise in the long Treas. yield up toward 5.25 - 5.50%.

From a technical perspective, the bond market now has a slightdownward tilt to yield when measured by 26 wk. momentum.It is neutrally priced against the 40 wk. yield m/a. 30 Yr. Chart.Since I like to trade extreme readings above / below the 40 wk. m/a,the bond is not interesting now.

Friday, February 05, 2010

Leading IndicatorsThe weekly leadings lost a little ground in recent weeks but remainin strong uptrends. There were negative short term reversals inunemployment insurance claims, sensitive materials prices and thestock market. My reading of the weekly indicators is that they areprobably due to come off the powerful trajectories they have beenon. However, there has yet to be a break in % momentum of theindicators when viewed yr/yr.

The monthly indicators -- heavily weighted to new orders -- didhit a new cyclical high in Jan. Momentum here is strong but isslowing. The services sector is on a moderate track and trails thestrong manufacturing sector by a significant margin. (The servicessector did not experience the inventory liquidation led free fall seenin manufacturing over H 2 ' 08.)

Key $ SeriesRetail sales, production in $, new factory orders, spending forcapital equipment and tech. and exports are also advancing withexports the clear leader. Housing remains in the doldrums withonly a hint that new purchase mortgage applications could finallybe bottoming after a 50% decline over the past five years. Profits,as mentioned yesterday, are also recovering rapidly.

Business Strength IndexThis index has improved rapidly over the past year and nowstands at 130.6. The Fed normally raises short term rates whenthe index breaks through 130 and gets into the 130 - 140 range.An issue here is that capacity utilization is still low. Moreover, thecapital stock is now shrinking. If policy is for exports to be aleader for the US as Pres. Obama insists, the Fed will have to beeven more mindful of operating rates going forward. After a boomin the 1990's, the US is due for a new round of greenfield expansionto put more productive equipment on line if it is to stay competitivedown the road.

Economic Power IndexThis index gives a quick look at underlying consumer purchasingpower. Persistent decay over 2007 - mid-2008 helped underwitethe deep recession. When inflation fell away in latter 2008, a largespurt up in the real wage saved the US from an even deeperdownturn. The index lost ground again over Half 2 '09, but didimprove sharply in Jan. as the real wage held up better, and astotal civilian employment increased. further improvement willbe needed over 2010 to secure continued economic recovery.

Capital Slack Index This measure is improving from the lowest levels seen since theend of WW2. With slack this ample, the odds favor a lengthyperiod of economic recovery / expansion that could easily runout to 2016 or longer before full tilt is hit.

GlobalThe rest of the world went off the economic cliff with the US overHalf 2 ' 08. Global recovery is underway, but its momentum, whenmeasured in new orders data, has leveled off. I would have to saythis is a disappointing development as weaker foreign credits likeGreece and Spain need to see rising business and household cashflows to buttress their revenue take.

Dragon Has Hoarded MaterialsWith official China now signalling that a touch of moderation of itsaggressive monetary policy may be in order, inventory speculationby China companies may be easing . Check out copper.

Thursday, February 04, 2010

I covered the cautious technical picture in the 2/1 post (below).Today, I focus on fundamentals and a bit on psychology. The SP 500closed today at 1063 after a sharp fall. But the market has reallyspent most of its time closer to the 1100 level for a good severalmonths. At 1100, the market is discounting 12 mos. earns. of $67.That's about where the consensus forecast is for 12 mos. earns.through mid-2010. So, I view the market as having stalled outafter it discounted earnings recovery out to the middle of this year.For my part that represents reasonable behavoir, as it gives timefor the underlying trend of earnings to catch up and "verify" theadvance.

As I discussed in the 2/1 post, I think the first leg of this cyclicalbull market was completed in recent weeks, with the sharpascent reflecting rapidly recovering profitabilty from a firstever small operating loss for the "500" in Q 4 '08, to a quarterlynet per share earning power of around $17 currently. Therecovery move was accomplished by the very aggressive costcutting of the component companies, advancing sales volumesoff a low base, and of course, the elimination of the bankrupt fromthe index.

As we go forward, we will see the development of modest yr/yrsales growth spread over reduced cost structures, which willsupport further earnings recovery over the second half of theyear. the cost cutting is a done deal, so now the focus for investorsis on the sales recovery. At this point, the leading economicindicators suggest that sales will continue to recover throughthe year on a yr/yr basis, but do not as yet provide signals onthe momentum of sales growth after mid-year. Again, it isunderstandable to me why the market would pause as it has.

From a psychology standpoint, I think it is also reasonable forinvestors to get a case of the shivers in the wake of a severe comborecession / financial crisis. It was a harrowing time andsubsequent concerns about growth or credit viability can work tore-generate some fears as mentioned back in the 9/18 piecewhen I first suggested some caution on the market. The classicexample was the 1932 - 33 period when the market ralliedfuriously off its low in the summer of '32, was then engulfed againby fears that hung around for more than six months, and with thisto be followed by a double to the upside in short order.

I think the economy is going to do ok and that the market advancewill resume. But I do not know whether the current sabbatical willlast until tomorrow morning or whether it will persist for a numberof weeks. The current round of "hot" shorter term cycles (13-15wks) suggest a bottom this month. We'll see.

Monday, February 01, 2010

I gave the charts a thorough review over the weekend. Back on Sep.18, '09 when I started turning cautious on the market, the SP 500went out at 1068. It closed at 1074 this past Friday. So, despite ameasure of intervening strength, the market staged a round tripover the said time frame. Over this interval, the market changedcomplexion. A lengthy period of winnowing volatility ended in mid-Jan. when a "fake" upside breakout ended and a correction began.That change in volatility plus the existence of three distinct uplegsin price off the 3/09 low strongly suggests to me that the firstmajor leg of this cyclical bull market has ended.

The recent price correction has eliminated overbought conditionsranging out to 40 weeks and did leave the market with a tradableoversold for short term players. However, to count on thedevelopment of a significant new upleg off the 1/29 low appears tome to be an against-the-house bet. History suggests that when thestock market comes off the kind of massive overbought conditionwe saw develop in latter 2009, it tends to have a relatively sterileperiod until the bulls can once again regain command. Unfortunately,there is no ready time measure to suggest when another upleg mightget started, but it rarely takes less than a good several months. Ihave also observed that when the market does come off a giantoverbought, it more often than not corrects / consolidates until ittests its 40 wk m/a (The SP 500 weekly chart linked to below showsthat the large gulf between the index and its 40 wk m/a is closingfairly quickly).

It does need to be said that when the stock market corrects after aperiod of consolidation as we have recently seen, one has to concedethat stocks could be transitioning to a more vulnerable period. Thattest may come over the next two weeks.